For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.

In 1900, farms were small, inefficient, and labor-intensive. About 41% of the workforce labored in jobs such as field hand, egg chandler, and hay baler. Food was expensive. The typical household spent 43% of its income on sustenance.[1]

Over the next century, tractors replaced horses; researchers developed higher-yielding grains and new irrigation and fertilization techniques; railways and highways created a national distribution network. Output soared, food prices plummeted, and labor left the farm for better opportunities. In 2014, the typical household spent just 9.7% of its income on food, produced by less than 2% of the workforce.[2]

A similar story of miraculous productivity gains and astonishing price declines reshaped just about every corner of the U.S. economy in the 20th century. Except one: financial services. Such is the dismal conclusion of a 2015 paper by New York University’s Thomas Philippon, “Has the U.S. Finance Industry Become Less Efficient?”

A price and productivity puzzle

In 1900, according to Philippon, costs in the U.S. financial services sector amounted to roughly 1.6% of “intermediated assets”—the savings, loans, and securities that underwrite investment and grease the wheels of commerce (in short, any financial asset that isn’t stuffed under a mattress). More than a century later, those costs amount to . . . roughly 1.6% of assets.

“It’s puzzling,” Philippon writes. “Advances in information technology should lower the physical transaction costs of buying, pooling, and holding financial assets.” Possible solutions to the puzzle include growth in household borrowing (households are more expensive to serve than corporate borrowers) and growth in the asset management industry, particularly as “high-fee alternative asset managers have gained market share.”

I suspect that Philippon’s data set, which runs from 1870 to 2012, ends too soon. That’s because the asset-management industry is only now beginning to realize the efficiencies generated by one of the greatest innovations of the late-20th century: the index fund.

The first unicorn

When the first index mutual fund began operations on August 31, 1976, Jack Bogle’s brainchild was a curiosity, a provocation in a largely academic debate about whether professionals could consistently outperform the market. It wasn’t even all that cheap, with a sales load and expenses equal to 0.43% of assets at the end of its first fiscal year.

As its assets under management increased, however, the innovation’s potential to grind down unit costs became clear. Like a Silicon Valley “unicorn,” the technology was scalable. In 1976, when fund assets totaled a little more than $14 million, annual fees for a $10,000 account were about $43. At the end of 2015, with more than $219 billion under management, fees for the same-sized account were just $5, an 88% reduction in unit costs.

These differences in labor efficiency show up in the prices we pay. At the end of 2015, the industry’s stock index funds had an asset-weighted expense ratio of 0.11%, according to the Investment Company Institute (ICI). Active strategies charged 0.84%.

Cost in the crosshairs

Indexing is now a well-established—and highly regarded—investment strategy, but it’s still in the early stages of adoption. At the end of 2015, according to the ICI, index strategies accounted for about 30% of mutual fund and exchange-traded fund assets, with especially strong growth since the global financial crisis.

Like Cyrus McCormick’s mechanical reaper, indexing has emerged as technology to reduce the cost of harvesting interest payments, dividends, and capital gains from the financial markets. And by putting cost at the center of the conversation, indexing seems to be having beneficial spillover effects on the higher-cost strategies that have gained market share over the past few decades, according to Philippon.

Scan the trade press, and you’ll see headlines about pressure on alternatives managers to lower their fees. In the mutual fund industry, investors are voting with their feet. As my colleagues David Walker and Don Bennyhoff noted, new cash flow is going overwhelmingly to the lowest-cost funds, index and actively managed.

The trend may not yet be visible in Philippon’s data, but asset management costs are coming down, and indexing is the catalyst.

[1] Gordon, Robert J., 2016. The Rise and Fall of American Growth. Princeton, NJ: Princeton University Press.

Andy Clarke

Andy is a senior investment strategist in Vanguard Investment Strategy Group. Before joining Vanguard in 1997, he worked at Morningstar. During his tenure at Vanguard, Andy wrote "Wealth of Experience," an introduction to investing based on ordinary people's stories about what has—and hasn't—worked as they've tried to meet their financial goals. Andy holds a B.A. from Haverford College and an M.S. from West Chester University. He is a CFA® charterholder.

Comments

Timothy L. | September 29, 2016 9:25 pm

I enjoyed this article. I like reading just about any article referring to Vanguard Index Funds. They are the same age as me. Too bad I didn’t know about them in my 20s. Thanks for the article, keep them coming. Thanks from Iowa.

Dom M. | September 22, 2016 10:08 am

As a senior, I have a sizable amount in VG bond/stock mutual funds. Given the market over the last 8 years,
with VG fees/costs, etc., I haven’t made much than if I had just placed my money in CD’s, without any fees or charges? Why I should continue with VG.

Thanks for the comment, and commendations on your attention to fees and the potential return available from different vehicles.

I can’t address your specific holdings, but I’d note that the past eight years have been a pretty good time to invest in the global stock and bond markets. Consider the annualized total returns of four broad market benchmarks from 8/31/2008 through 8/31/2016:

These benchmark returns are different from any given fund’s returns, but they give you a sense of the investment environment. You might want to log on to vanguard.com, look at your “personal performance,” and compare it with the CD rates that were available to you in 2008. (Unlike stock and bond funds, of course, FDIC-insured CDs protect you from any risk of loss.)

As for why to continue with Vanguard? I guess the first question would be whether your stock and bond fund holdings are consistent with your goals for the long-term growth and stability of your portfolio (vanguard.com offers educational material that can help you think through this question). If the answer is “yes,” you’d want to make sure to control your costs in order to maximize your share of the fund returns. That’s a Vanguard specialty. Vanguard funds are among the lowest-cost options in the mutual fund industry.

Anup C. | September 9, 2016 2:04 pm

Richard G. | November 28, 2016 10:16 am

To Mr. Anup, C.Sir you asked what index fund you needed for a 70 year old. I am a lowly client of Vanguard but I will give you an answer. On a blog you can never be given specific guidance because you reveal no financial information about your self.A reputable CFP needs to know exactly what you have before they can suggest a financial program to meet your goals.You can set up an index program to give you income now,growth for the future, tax shelter your income or many other ways to gain your goals.Your money can work for you 24/7 but you have to tell it what you want it to do.An investor who has reached 70 years of age should be in a position where they have already “made their hay”and are pretty well off.If you have this luxury then you may need to have a lot of tax management with your program. If you are facing your retirement with a $1500.00/mon S.S. heavy in debt and very little saved then you may want to look at growing your portfolio to give you more stability in the future. Please call Vanguard and give them your financials. They will be glad to point you into the right index funds for you based on what your goals are. Good Luck in your retirement Sir!

William A W. | September 9, 2016 7:09 am

Donald G. | August 13, 2016 1:18 pm

Mr. Clark-I am confused. Vanguard lists May 1, 1975 as it”s beginning date.They also list Wellington fund which started in 1929 as Vanguard oldest mutual fund.It seems that we have a 46 year discrepancy between 1975 and 1929.Was this fund “grandfathered in”? I am sure that there is a very logical explanation.A totally sold on Vanguard.

Thanks very much for the question and comment. Yes, a complicated but logical explanation.

Vanguard Wellington™ Fund did indeed begin operations in 1929, managed by Wellington Management Company. In 1974–1975, John C. Bogle (at the time Wellington’s CEO) created Vanguard as a new company to handle administrative functions for the Wellington Fund and other funds managed by Wellington. The new company, which began operations on May 1, 1975, was owned by these funds.

Over the past 40-plus years, Vanguard’s mandate and capabilities have expanded dramatically, but we still work closely with Wellington, which continues to manage Vanguard Wellington Fund and a number of other Vanguard funds.

When Vanguard group will open branches in India ? As there are no proper low cost index funds in India. While there is a huge demand for low cost index funds ,ETFs ,Target retirement and life cycle funds. Dr. Anil Gupta M.D. Cardiologist / Boglehead.

Dr. Gupta,
Thank you for your comment and your interest in our funds. While we are not currently in the Indian financial markets, we continually study new products and markets across the globe. Best of luck to you in your retirement planning!

Now-famed investor John Templeton is noted for, during the Depression of the 1930s, buying 100 shares of each NYSE listed company which was then selling for less than $1 a share ($17 today) (104 companies, in 1939), later making many times the money back when USA industry picked up as a result of World War II.
— The market was beaten down as a result of the recession of 1937.
— Index investing somewhat resembles Templeton’s tactic pre-WWII,
— It takes a bit of cost to separate the good from the bad. Which leads us to the Grossman-Stiglitz economic paradox: There is a balance between making money off of research separating the good stocks from the bad stocks, and making money off of ‘free-riding’ off such efforts by others.
— It is a pity that no one has found much to make financial research more efficient. It is more of an art than a science.

Carlton S. | August 5, 2016 2:01 pm

There is all sorts of “financial research” that is based on statistical data mining of the past performance of stocks versus other variables such as p/e ratios or sunspot activity, in an effort to predict their future performance. Even in cases where there is a “statistically significant” correlation between variables that has an rational basis, investors attempting to “cash in” on that past performance will simply bid up the price of certain assets prematurely, such that their future performance is likely to be no better than the overall market, and perhaps worse. That’s how efficient markets work, which is why typical investors will do best by investing in funds that are well diversified and have low expenses.

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For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.